As we await the results of the French and Greek elections, there has been a considerable change of focus in the eurozone from the paradigm of all-austerity-all-the-time to growth strategies. The villians, according to those who push back at the “fiscal compact”, is Angela Merkel and, to a lesser extent, Mario Draghi.

What I don’t get is that many analysts have failed to understand (see the post by Yves Smith as one example out of many) is that Draghi has said repeatedly said that the long-term plan has two components:

“Good austerity” in the form of lower taxes and lower government spending. But the Grand Plan isn’t all austerity, all the time. The second component addresses the problem of the competitiveness gap between northern and southern Europe, which means:

Structural reform, which is the European version of the step China took to “smash the iron rice bowl” in order to create labor flexibility for all, not just the young but all of the current employees in their cushy jobs and gold-plated pension plans. Draghi went on to characterize structural reform as the old days of the European social model being all gone.

The president of the European Central Bank (ECB) said it was of “utmost importance” for leaders to impose fiscal discipline but also to generate growth by “facilitating entrepreneurial activities, the start-up of new firms and job creation”.

He echoed demands for a “growth pact” from leaders including the French presidential hopeful, Francois Hollande. But rather than protectionist policies advocated by some, Mr Draghi said his ideal growth pact would be based on free labour markets and structural reforms that would be “agreed collectively, not unlike the fiscal [pact]”.

He said political commitment would be “the most important” part: “Collectively we have to specify the future of the euro; where do we want to be in 10 years’ time?”

The “growth compact” in micro and macroeconomic terms
I feel that the market still doesn’t really get Draghi’s “growth compact”. Let me try to explain it in micro and macroeconomic terms. In microeconomic terms, it addresses the barriers to business formation in many Club Med countries. Simply put, it’s hard to fire people. The “growth compact” is an Anglo-Saxon, or Thatherite, solution to make it easier to terminate employees. This is what Draghi meant when he stated in the WSJ interview that “the European social model has already gone”. His reasoning is illustrated by his response that the current arrangement is inherently unfair to the youth of Europe [emphasis added]:

WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.

The Anglo-Saxon reasoning goes, if it is easier to fire people and make them work harder or take away their gold plated pensions, it creates more opportunity for growth and business formation.

In microeconomic terms, the “growth compact” is structural reform, pure and simple. In macroeconomic terms, the “growth compact” means an internal devaluation by the peripheral countries in the eurozone, which is a fixed exchange rate regime. The Greeks, Italians, Spaniards, etc., just have to work harder and get paid less.

Projecting the gains under a “growth pact”
What are the possible gains under such an internal devalution? FT Alphaville reports that Morgan Stanley’s Joachim Fels and Elga Bartsch took a stab at the problem:

Morgan Stanley projects that the Club Med countries (which include France) could gain about 15% of GDP growth over 10 years if they adopted these structural reforms. This amounts to an average of 1.5% of GDP a year, which is considerable when you consider that the long-run real growth rate in Europe has been hovering around 2% per annum.

Martin Wolf of the FT showed some analysis in a presentation on May 3, 2012 to the National Economists Club and Petersen Institute for International Economics. My conclusion, in the context of the “growth compact”, is that the Club Med countries should try to become more like Ireland.

Note how unit labor costs in the troubled peripheral countries have been rising relative to Germany – all except for Ireland. These structural reforms that make it easier to hire and fire people, or internal devaluation, could get unit labor costs down below German costs and make Greece, Spain, etc., look more like Ireland.

Also note from the first chart how low Morgan Stanley has projected Ireland’s gains from structural reforms are, indicating that Dublin has already made the hard choices. This also means that Ireland will be the poster child for the growth pact and structural reform. The preliminary indications appear to be positive. This CNBC report discussing the upcoming Irish referendum on the fiscal compact shows that business are re-locating to Ireland “attracted by its relatively low corporation tax and increasingly cheap workforce”:

Some of the forward-looking indicators for the Irish economy have been more positive. Tax revenues for March are 370 million euros ($486 million) ahead of target in the year to April 2012, driven by healthier corporation tax revenues as companies move to Ireland, attracted by its relatively low corporation tax and increasingly cheap workforce.

Nevertheless, I would expect that the trajectory of Irish growth will be scrutinized intensely to see if the harsh medicine is working.

A more realistic scenario
If all eurozone countries were to adopt the structural reforms that Draghi advocates and the Morgan Stanley analysis is correct, Germany would also gain 12.5% in GDP growth per annum. The spread between Spain and Germany is only 2.5% over 10 years, or 0.25% a year – hardly worthwhile.

Let us assume a more realistic scenario. Supposing that the peripheral countries were to adopt some form of structural reform, but only get two-thirds of the gains projected by Morgan Stanley, i.e. about 10% instead of 15% over 10 years. Assume, at the same time, that the Germans rest on their laurels. Indeed, former IMF chief economist Simon Johnson wrote in Bloomberg that German Unions Seeking Higher Pay Could Save the Euro [emphasis added]:

The solution involves a move straight out of the gold-standard playbook, with a modern twist. Since monetary union began, Germany has had substantial productivity gains and only moderate wage increases, making it highly competitive. Eurostat reports that German wages rose 2 percent a year from 2000 to 2009, while Spanish wages increased by 4.7 percent a year in the same period — more than twice as fast. Because the currencies are the same, Germany’s competitiveness has made it tough for Spain and the other weaker states to sell their products in the euro area.

But the cavalry may show up in the unlikely form of German trade unions, which are seeking big wage increases this year. Recent demands by German workers range from 3 percent to 6 percent. As Bloomberg News reported, IG Metall, Europe’s biggest labor union with about 3.6 million workers, is demanding 6.5 percent more pay at a time when inflation is about 2 percent.

This isn’t crazy. German unemployment is at its lowest level in two decades. German exports have been doing well around the world. To some monetary purists, talk of higher wages suggests that the European Central Bank’s policy is too loose for current German conditions. But this is really taking an idealized version of the gold standard too far.

The point is to have relative wages and prices adjust — higher for Germany and lower for its European trading partners. If German incomes rose, German consumers would have more disposable income with which to buy imported goods. And lower labor costs in other European countries would make their goods and services less costly, giving them a leg up against Germany’s export machine.

If the people in charge — mostly Germans at this point — insist that the adjustment must come entirely through a fall in the absolute level of wages and prices in countries with current-account deficits and large amounts of debt, then Europe is in for a difficult, and perhaps lost, decade.

But if part of the adjustment can come through higher German wages — recognizing productivity gains and consistent with continued prosperity — the path forward will be easier.

In other words, German wages go up while Club Med wages go down. Both Germany and the peripheral countries take actions to bear the cost of this internal devaluation.

The big question
Here is the big question. Assuming that the peripheral countries enact these structural reforms that make them more Anglo-Saxon. Would that create sufficient incentives for big employers like Alstom, EADS, BMW, Siemens to locate plants in Valencia, Thessaloniki or Lisbon, instead of looking at Poland or Slovakia as they do now?

I don`t know. What I do now is that the ECB has always had an agenda, or wish list as outlined by this analysis:

The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.

To the extent that member states are willing to go along with the ECB, it has shown an inclination offer the carrot of supporting the harsh adjustments necessary with easy monetary policy and unconventional policies, such as LTRO. On the other hand, it has the stick that, if a member state were to falter, the ECB has the option of leaving that government to the mercy of the bond market wolves.

Draghi realizes that these prescriptions are harsh and that`s why he used the analogy of crossing the river in this report:

Structural reforms are essential to restoring competitiveness but will also cause pain in the short term, the ECB president said.

“Structural reforms hit vested interests,” he said, adding that they “change profoundly the society.” These changes are themselves “a source of pain,” he added.

“We are just in the middle of the river that we are crossing. The only answer to this is to persevere and for the ECB to create an environment that is as favourable for this as possible,” Draghi said.

Notwithstanding the news flow over the pending elections, the fight over austerity and structural adjustments is by no means over, regardless of the electoral outcome.

My bet, in the long run, is still on Draghi and Merkel. In the short run, however, anything can happen.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Have US equities seen an intermediate term top? It was a rough week for stocks last week, but I believe that we are due for an oversold relief rally. We will need to watch how the market behaves in the next couple of weeks in order to truly determine whether an intermediate term top is in.

As the chart below shows, the market briefly tested the 50-day moving average and managed to rally above that support level and the longer term uptrend remains intact.

You would be forgiven for imagining that investors are allergic to owning stocks, given the data surrounding equity fund flows. For the last 12 months, as shown in Chart 4, below, investors have demonstrated at best a grudging affection for stocks.

These are typically not the kind of levels of sentiment indicator readings that mark the start of a major decline.

The NFP release a statistical blip?
In addition, the shocker of a 120K NFP release that was the catalyst for the recent stock market selloff may have been a statistical blip. Ed Yardeni outlined last week why he remains constructive on employment picture:

(1) The three-month average gain of payroll employment remains solid. Payrolls rose 211,700 per month on average during Q1-2012 vs. 164,000 during Q4-2011 and 127,700 during Q3-2011. Private-sector payrolls rose 210,300 on average during Q1 according to the official tally, in line with the 207,000 average gain for the payrolls tracked by ADP.

(2) The index of aggregate weekly hours worked for total private industries rose at a solid pace during Q1. It was up 3.7% (saar), following increases of 2.5% during Q4-2011 and 1.1% during Q3-2011.

(3) The household employment survey is up 414,700 per month on average over the past three months. That compares to gains of 227,700 during Q4-2011 and 240,700 during Q3-2011.

(4) According to the household survey, full-time employment rose 882,000 during March! That’s not a typo, and that’s after it rose 563,000 during February. On the other hand, part-time employment fell 664,000 during March after falling 163,000 during February. Full-time employment is up 4.8 million since its latest cyclical trough during December 2009 to the highest level since the start of 2009.

Also consider the latest batch of other employment indicators:

(5) During March, initial unemployment claims averaged 361,750, falling steadily from September’s average of 410,500. That’s a clear sign that the pace of firing is continuing to decline.

(6) A monthly employment index, which can be constructed from the available regional surveys conducted by the Fed districts and purchasing managers associations, remains strong. So far for March, data are available for the regions around the following cities: Chicago, Dallas, Kansas City, New York, Philadelphia, and Richmond. The average of these regional indexes fell from 14.5 during February to 12.2 last month. That’s still a relatively high reading.

(7) On Wednesday, Gallup reported a four-point jump in the polling firm’s Job Creation Index from 14 in February to 18 in March. That’s the best reading since August 2008. The latest poll also found that the pace of hiring is picking up: “The March Job Creation Index reflects 35% of U.S. adult workers saying their employers are hiring and expanding the size of their workforces, and 17% saying their employers are letting workers go and reducing the size of the workforces. While the percentage letting go matches what Gallup found in January, the percentage hiring is at a 42-month high, last seen in September 2008.”

(8) The employment component of the national manufacturing purchasing managers index (M-PMI) jumped from 53.2 in February to 56.1 in March, the best reading since last June. The nonmanufacturing survey’s employment index increased from 55.7 in February to 56.7 in March. The average of the M-PMI and NM-PMI employment indexes rose to 56.4 in March, the highest since last June.

(9) Wednesday’s ADP report also confirmed that the labor market remained strong during March. During Q1, the average gain was 207,000, little changed from Q4’s 211,700 and considerably above the 99,000 average during Q3 of last year.

What the bears say
Based on the analysis so far, one may be inclined to give the bulls the benefit of the doubt, but inter-market analysis reveals a far more bearish tone. There are a number of worrisome negative divergences that shouldn’t be ignored. For one, eurozone concerns are rising and the risk of financial contagion from Europe is rearing its ugly head again. European stocks have violated their uptrend and they have rolled over. The STOXX 600 Index, shown below, is now approaching the first technical support at the 61.8% Fibonacci retracement level.

In addition, commodity prices look punk.

The relative performance of the Morgan Stanley Cyclical Index is also following the pattern of commodity prices.

If we are truly seeing a recovery in the American economy, shouldn’t cyclical stocks be outperforming? In summary, we have trouble in Europe, weakening cyclicals and commodities. Do these look like the ingredients for a sustainable advance?

Staying on hold, but watching
Today, what we have right now is an oversold market that is due for a relief rally of at least 1-2 weeks in duration. In the meantime, Earnings Season is upon us with the possibility of margin compression weighing down the market (see my post Bad news is good news, good news is…). I am watching earnings reports carefully for whether margin compression is occurring this quarter, as I have to allow for the possibility that it may be pushed out to the next quarter’s earnings reports.

In summary, I wrote before that investors should maintain a balanced outlook between risk and return (see Time to take some risk off the table). My current stance is to watch how the market behaves and reacts to news in the next few weeks in order to get a better idea of intermediate term direction. Specifically, I am watching for:

Earnings and forward guidance: Are margins compressing now or next quarter?

Market leadership: How are the cyclicals and commodities behaving?

European news, as we have elections in France and Greece coming up soon and the fear of European contagion could rise.

Stay long, but keep tight trailing stops in place.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

I’ve been pretty bearish in the last few months, but it may be time to change my outlook. Last week, the Asset Inflation-Deflation Trend Model moved from a deflation to a neutral reading. As a confirmation of this trend, my review of the charts show a picture of global healing after the trauma last year of a near banking crisis meltdown in Europe.

Is LTRO the Draghi Put?
Most notable is the performance of the banks. The relative performance of the Banking Index shows a pattern of a rally through a relative downtrend. The ECB’s LTRO program of providing unlimited liquidity for up to three years to eurozone banks has bought the politicians time and created the perception of a Draghi Put for the market. The recent relative performance of the BKX, which is heavily weighted with the large TBTF banks, is reflective of this relief.

Similarly, the performance of the Euro STOXX Index shows a pattern of global healing. Despite all of the financial stress evident in the eurozone, this index formed a wedge and the wedge resolved itself to the upside.

In addition, we have been seeing positive European price action in the face of bad news, which is bullish. I wrote last week that European banks have been testing a key support but that level has been holding up, despite all of the bad news in the last few months. Italian 10-year bond yields, which is a key measure of investor confidence, has stayed below the important 7% level in the face of the downgrades.

Inter-market analysis confirms the turnaround
Sectorally, I am seeing signs that the market expects a cyclical rebound, at least in the US. The chart below shows the relative performance of the Morgan Stanley Cyclical Index against the market, which has been rallying and is now in the process of testing a relative resistance level.

The Industrials are also showing a similar pattern of relative strength as the sector began a relative uptrend in October.

So have the Materials sector, which show the familiar pattern of rallying through a relative downtrend:

…while defensive sectors such as Utilities have lagged the market and is now in the process of testing a relative support level.

Constructive on commodities
Commodity prices are also showing signs of global healing. The chart below of the CRB Index shows that commodities have rallied through a minor downtrend and it tested the longer term major downtrend, which remains intact.

The commodity heavy Canadian market is also showing a similar pattern of rallying through a short-term downtrend, though the longer term major downtrend remains intact.

Regular readers know that I am a long-term commodity bull. These charts indicate a constructive outlook on the commodity complex. Mary Ann Bartels of BoA/Merrill Lynch recently showed that large speculators (read: hedge funds) have unwound their crowded long in commodities and readings have retreated to a level where previous bull phases have begun in the past:

Positive breadth divergence
Tom McLellan, writing at Pragmatic Capital, has confirmed my observation of a market turnaround. He wrote that the Ratio Adjusted Summation Index is showing strength:

So all of this leads us to the current RASI reading, which at +618.2 is above the +500 level but still below the peak of +763 seen on Nov. 15, 2011. So it is a divergent lower high, but it is still high enough to say that the uptrend which started in October 2011 is not over. There can be ordinary pullbacks along the way, but the message of the RASI is that the final highs of this current new uptrend have not yet been seen.

In addition, China isn’t out of the woods. While the Chinese leadership is making noises about stimulus, the property bubble in China is deflating in a dangerous way and it is unclear whether the authorities can achieve a soft landing. The Shanghai Composite has been rallying in line with global equity markets but the index remains in a downtrend. The one silver lining for the bulls is that there appears to be a turn-of-year effect in Chinese equities. The current rally is consistent with the pattern of market updrafts seen starting at about the time of past Lunar New Years.

Since China’s economy remains a major engine of growth in a growth-starved world, this is one indicator to watch carefully. The bulls can also take solace in the Hong Kong market, which formed a wedge that resolved itself to the upside recently:

In addition, Nomura believes that Chinese real estate may be in the process of forming a bottom. The firm’s analysts pointed to a positive divergence between land purchased by property developers and new construction activity:

Cautious short-term, constructive medium term
Putting it all together, what does this all mean?

My inner trader tells me that in the short-term, the rally looks overdone. Over the next few weeks, continue the strategy of buying weakness and fading strength. Indeed, Macro Story confirms a high risk level for equities by pointing out that AAII sentiment is at a bullish extreme, which is contrarian bearish.

With US equities now testing a resistance level, expect some short-term weakness but be prepared to buy the dips:

Longer term, my inner investor tells me to expect a period of sideways consolidation, likely followed by a bull phase in equities with an expected return of 5-15% in 2012 – assuming that there are no accidents.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

I urge all investors to have a game plan for the year ahead and beyond. Despite all of our best efforts, our forecasts can and will fail and how you react to the change in direction is more important than the decision you take today.

Strategies for different parts of the cycleBarry Ritholz recently showed a series of charts of the economic cycle and how investors should react to them, two of which I show below. However you approach the market, whether it’s asset and sector rotation, or stock picking, recognizing your investment environment is key to alpha generation. This chart shows the analytical framework for the asset and sector rotators:

And this one is a framework for the stock pickers:

Be tactically aware of the investment environment
My approach is to become more tactical in my asset allocation using my Asset Inflation-Deflation Trend Model. An article in Registered Rep shows how many investment advisors are turning to tactical asset allocation as an investment solution to dampen portfolio volatility:

Following the twin market implosions of the past decade—first tech, then real estate—many retail financial advisors are looking for more tactical, meaning active, asset allocation solutions for client portfolios to dampen volatility, improve total returns and avoid market catastrophes. At least some of them fear that if they don’t dramatically change the way they allocate client portfolios, moving away from traditional buy-and-hold investing strategies, they could lose clients. So say a handful of advisors and an investing expert.

Not becoming more tactial could pose a business risk:

Things could get especially bad if another bear market hits, says Ron Carson, founder and CEO of Carson Wealth Management Group. “[Investors] are hanging on by a thread right now, and I don’t think they’re going to forgive.” A Natixis Investor Insights Study found that 63 percent of investors are now paying more attention to risk than ever before. If the market nose-dives, advisors are going to want to have a different story to tell. They can’t just tell clients to hang on and wait it out like many of them did in 2008.

The movement to tactical asset allocation has turned from a trickle to a flood:

According to a survey by Cerulli Associates, the number of FAs using either a pure tactical allocation or strategic allocation with a tactical overlay is now at 61 percent, up 8.3 percent from 2010. A Jefferson National survey from September 2011 found that 75.5 percent of advisors believe that active portfolio managers can outperform an index over the long term. In Jefferson National’s 2010 survey, 66 percent of advisors said clients were more confident with a tactical asset management strategy, while only 34 percent said clients were more confident with a traditional buy-and-hold strategy.

Are you betting the farm?
Stocks didn’t go anywhere in 2011. In fact, they haven’t gone anywhere since the NASDAQ peak in 2000. In the current low-return environment, advisors find that clients are less forgiving of draw-downs in their portfolio.

In days past, the practice of overweight a portfolio with a manager to make a big style or macro bet that “looks through the economic cycle”, e.g. a value manager, was perfectly acceptable. The downside to managers that make such style bets is they tend to badly underperform during certain periods when their style is out of favor – and investors are far less tolerant of such draw-downs in the current volatile and low return environment.

As an example, there were numerous managers who were wary of internet stocks during the Tech Bubble runup. I had watched many good managers and strategists go down in flames because they were one or two years early because their investors couldn’t stand the underperformance. Today, investors are highly intolerant of negative volatility, largely because of the low return environment that we have been stuck in for the last decade.

Have an investment plan
The message is clear. Take control of your portfolio. Be aware of the investment environment. Your investment philosophy and objectives are up to you. However, you should make sure that you have engineered your portfolio’s risk profile sufficiently so you survive to get to your objective.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.